Paradigm Shift Coin Flip: Equities vs. Bonds

Includes: AQQ, DIA, QQQ, SPY
by: Dorsey Wright Money Management

This has become an intriguing area, especially for the value crowd. For example, the Financial Times shared an interesting tidbit:

… this market dislocation creates a more intriguing yield comparison – based on cold, hard cash. The S&P’s dividend yield of 2.23 per cent exceeds the yield available from bonds over a decade. This has not happened in decades, and implies that, for anyone parking money in the hope of a recovery, the opportunity cost of doing so would be lower in a passive index holding than in bonds.

In fact, I don’t think U.S. equity yields have been higher than Treasury yields on a sustainable basis since the 1950s, although they popped slightly above Treasurys at the bottom in 2008. The U.S. equity market is pricing in incredibly low expectations for earnings growth. On the other hand, Japan has had persistently low bond yields for two decades — and investors keep buying them.

There is no telling at this point whether, like 2008, this represents a tremendous buying opportunity or if we have undergone a paradigm shift (or re-shift, if we are headed back to the 1950s) and the new yield relationship will be stable. After all, the “new” yield relationship was the one in place from the 1890s through the early 1950s.

Which 60-year period was the aberration?

This dilemma points out one reason we prefer using relative strength to value. Relative strength is just more tractable. It is a simple matter of mathematics to determine which of an array of assets is stronger. Relative strength is also logical. Doesn’t it make intuitive sense to try to have your assets in the strongest areas at any given time?

Valuation is much more difficult, especially when confronted with a possible paradigm shift. If you rely solely on historical valuations and assume they will go back into alignment, every paradigm shift will break your model. As in the case of Japan, you might not recognize that a paradigm shift has occurred until many years after your thesis has not panned out.

Implementing either relative strength or value strategies is likely to generate good returns over time, which is not to say that either strategy is easy. Easy and profitable don’t often co-exist. There are going to be bumps in the road either way, but a systematic implementation of relative strength just seems simpler to me.